Options Basics: Why Use Options?
  1. Options Basics: Introduction
  2. Options Basics: What Are Options?
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types Of Options
  6. Options Basics: How To Read An Options Table
  7. Options Basics: Conclusion

Options Basics: Why Use Options?

There are two main reasons why an investor would use options: to speculate and to hedge.

You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way. (For more on this, see Married Puts: A Protective Relationship and A Beginner's Guide To Hedging.)

A Word on Stock Options
Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a third reason for using options. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between two parties that are completely unrelated to the company. (To learn more, see The "True" Cost Of Stock Options.)

Options Basics: How Options Work

  1. Options Basics: Introduction
  2. Options Basics: What Are Options?
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types Of Options
  6. Options Basics: How To Read An Options Table
  7. Options Basics: Conclusion
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Maturity

    The period of time for which a financial instrument remains outstanding. ...
  3. Employee Stock Option - ESO

    A stock option granted to specified employees of a company. ESOs ...
  4. Implied Volatility - IV

    The estimated volatility of a security's price.
  5. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  6. Normal Profit

    An economic condition occurring when the difference between a ...
  1. What is the difference between in the money and out of the money?

    In options trading, the difference between "in the money" and "out of the money" is a matter of the strike price's position ... Read Full Answer >>
  2. How can I profit from a fall in the automotive sector?

    You can profit from a fall in the automotive sector by short selling automotive stocks and exchange-traded funds (ETFs) or ... Read Full Answer >>
  3. Are warrants more desirable than options?

    Warrants are typically considered less valuable than options, although they do offer the advantage of having significantly ... Read Full Answer >>
  4. How do I build a profitable trading strategy when using Pivots?

    Developed by floor traders as an easy way to gauge market tendency based on the prior session's performance, pivot trading ... Read Full Answer >>
  5. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. What is a stock split? Why do stocks split?

    All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!